Comptroller Dugan Discusses Lessons from Financial Crisis

WASHINGTON — In the last formal speech of his five-year term as Comptroller of the Currency, John C. Dugan said the financial crisis had exposed glaring gaps and differences in the regulation of different types of financial institutions and made clear the need for an updated capital framework.

"The fact is that our financial regulatory system was designed to be extremely bank centric," he said in a speech to the Exchequer Club. "Extensive rules and tremendous supervisory resources were focused on banks, with far less of both devoted to other types of financial firms. As these other types of firms became much more significant in the delivery of financial services through the growth of securitization, structured products, and derivatives, our bank-centric regulatory apparatus was not adjusted to keep pace."

In the years leading up to the crisis, the different regulatory regimes made it impossible to apply the same capital and prudential standards across the board to all of the firms involved in various financial product areas, he said. Once the crisis hit, the government did not have the same stabilizing tools, such as the Federal Reserve’s discount window, to deal with nonbanks as were available for banks.

“As a result, perhaps the single most important part of the Dodd-Frank Act is its ambitious set of provisions intended to address these gaps and differences,” the Comptroller said, referring to the financial reform legislation signed into law today. “The regulatory paradigm has clearly shifted away from limiting the scope of intense financial regulation to institutions that enjoy explicit access to the federal safety net of deposit insurance and the discount window, namely banks. Instead, such regulation will now apply to all systemically important financial institutions, whether or not they are banks. That is a true sea change.”

Mr. Dugan took note of the systemic risk authority passed by Congress in 1991 following another banking crisis, which was used to address problems at large individual financial firms about to fail, as well as to temporarily guarantee the obligations of a wide range of financial institutions. He added that this “too-big-to-fail” provision proved to be unfair in practice, at least to the extent it protected individual large institutions that were troubled while small banks were closed.

“But here’s the thing of it: in the middle of the crisis, it worked,” he said. “Despite its unfairness, the moral hazard it created, and the severe political problems it generated, the FDIC’s systemic risk authority made both the financial crisis and the Great Recession, as bad as they have been, far less catastrophic than would otherwise have been the case.”

The Dodd-Frank bill is right to try to avoid the clear unfairness of this provision by adopting a new orderly resolution mechanism that can achieve the same results without bailing out uninsured stakeholders, he said, adding: “I only hope it works as well to maintain stability and restore confidence if, heaven forbid, we face a similar crisis in the future.”

On the subject of capital, Mr. Dugan said that while the Basel II capital framework was aimed at traditional banking activities, one of the hard lessons of the financial crisis was that most of the severe losses in the early stages of the market disruptions came from trading activities, which will be addressed in the Basel III capital rules now being developed.

“Even more important, however, have been the crisis-learned lessons about the quality of capital,” he said. “The crisis made plain that so-called Tier 1 capital had become too far removed from the most loss-absorbing form of capital, namely common equity.”

The Basel III process has focused heavily on developing a tight, strong, and transparent definition of common equity that would govern the core of required capital going forward for banks around the globe,” Mr. Dugan said. “I am pleased to say that the Basel Committee is making excellent progress in doing just that. And the same is true with respect to the development of a credible backstop leverage ratio.”

The most significant challenge for the Basel Committee and international policymakers, however, will be determining the amount by which the level of required capital, especially common equity, should increase, he said.

“There is a regulatory consensus that capital levels need to increase so that the banking system is not nearly as vulnerable to such devastating systemic problems in the future when the next round of significant unexpected losses occurs, as will surely happen sooner or later,” Mr. Dugan said.

However, Mr. Dugan added, at some point, increases in capital levels become counterproductive by causing banks to reduce lending in order to shrink their balance sheets.

“We need to require banks to be safe enough to provide credit even when unexpected losses occur but not so safe that they choke off credit,” he said. “Striking that balance will be the critical challenge facing policymakers in the next several months – made more difficult, perhaps, by today’s economic environment of fragile recovery.”

How that balance is struck, he said, “could have a profound effect on the future shape of the banking system, especially for large, internationally active banks.”